1. Options Basics: Introduction
  2. Options Basics: What Are Options?
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types Of Options
  6. Options Basics: How To Read An Options Table
  7. Options Basics: Conclusion

There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. (For more on this, see Married Puts: A Protective Relationship and A Beginner's Guide To Hedging.)

A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company. (To learn more, see The "True" Cost Of Stock Options.)

Options Basics: How Options Work

Related Articles
  1. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
  2. Investing

    Types of Options

    There are many different types of options. In addition to general put options and call option, we will discuss 13 different types of options. Some of these option types are better suited to day ...
  3. Trading

    Reducing Risk With Options

    If you want to use leverage to your advantage, you must know how many contracts to buy.
  4. Investing

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  5. Trading

    Introduction - Day Trading and Options

    Options have not been a tradition part of day-trading strategy, but this is quickly changing.
  6. Trading

    Hedging With Puts And Calls

    This trading strategy can reduce your risk - but only if you use it effectively.
  7. Trading

    Cut Down Option Risk With Covered Calls

    A good place to start with options is writing these contracts against shares you already own.
  8. Trading

    Is it Risky to Invest in Options?

    Investing with options can be a great strategy, but you need to do your research first or the risks can outweigh the benefits.
  9. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  10. Investing

    The Basics Of Option Price

    Options can be an excellent addition to a portfolio. Find out how to get started.
Trading Center